Previously, we examined three main factors conspiring against investors seeking higher expected returns. These factors can combine to generate a “perfect storm,” at least from an investment perspective, facing today’s investors. We then turned to the four most effective ways that investors can fight these head winds, which, oddly enough, have nothing to do with investing. We’ll now cover some additional investing-related steps you can take to help ensure you don’t run out of money in retirement.
Increase Your Equity Allocation
While today’s higher valuations do forecast lower future returns, this doesn’t necessarily mean stocks are overvalued, just more highly valued than historically has been the case. I’ve explained previously why higher valuations aren’t signaling overvaluation, as many gurus have been stating. And while higher valuations do forecast lower returns going forward, there’s still a relatively large equity risk premium.
The S&P 500 has an expected return a full 4.5 percentage points higher than the five-year Treasury (specifically, the difference between a 4.2% expected return and a -0.3% expected return). While lower than the historical premium, that’s certainly not economically insignificant.
However, raising the equity allocation in your portfolio does entail taking on significantly more risk, which you should consider only if you truly have the ability, willingness and need to do so. Especially with stocks, the higher expected return is called a risk premium for good reason. Thus, while it’s an option worth contemplating, it wouldn’t necessarily be my first choice.
Increase Your Allocation To International Stocks
Unfortunately, most investors have a significant home-country bias. They believe that the stocks of their home country are not only safer, but have higher expected returns (an illogical conclusion). As a result, investors tend to dramatically overweight their equity investments in their home country relative to the way the world allocates capital.
This phenomenon isn’t just found in the United States; it’s a global occurrence. Today U.S. equities make up only about 50% of the world’s total market capitalization for stocks. Thus, a logical starting point for thinking about this issue is to have half of your equity allocation in international stocks. Yet the typical investor allocates only a small fraction of that amount outside their borders.
Now, there are some good reasons to have a small home country bias. The first is that investing in U.S. stocks generally can be a bit cheaper. For instance, expense ratios of domestic mutual funds and ETFs tend to be lower. The second is that U.S. stocks can be a bit more tax efficient, especially in tax-advantaged accounts, because of issues related to foreign tax credits.
On the other hand, if you’re in the workforce, it’s highly likely that your labor capital (which, for younger workers, can be their largest asset) is highly correlated with domestic economic and geopolitical risks. That should lead to a bias to allocate more to international assets.
How would increasing the allocation to international stocks impact expected returns today? The CAPE 10 for non-U.S. developed nations is currently about 15. That produces an earnings yield of 6.7%. Making the adjustment for the five-year lag produces an expected real return of 7.4%, or 3.2 percentage points more than for U.S. stocks.
Thus, every 10% increase in your allocation to these stocks relative to U.S. stocks would raise the expected return of the portfolio by 0.32%. In a portfolio with 60% equities, a 50% allocation to international developed-market stocks instead of a 0% allocation would increase the portfolio’s expected return by almost 1% (30% x 0.32%). That’s a dramatic improvement.
That said, it must be noted that international stocks have lower valuations for a reason. They are perceived to be riskier. In other words, the higher expected returns are not a free lunch.
However, adding more international stocks provides diversification benefits. Thus, in my view, increasing your allocation to international stocks is a superior alternative to simply raising your overall equity allocation. Of course, you can consider doing both.
Before moving on, we need to discuss another type of risk. It’s a psychological one that for most investors is very real. It’s known as “tracking-error regret.” Tracking error is defined as underperformance versus a benchmark. Most often, the benchmark is a commonly referred-to index, such as the S&P 500.
If your portfolio consists solely of an investment in an S&P 500 index fund, then you’re not exposed to any tracking error risk relative to that benchmark. However, your portfolio isn’t well diversified, being exposed only to large-cap U.S. stocks. Once you diversify beyond that index, to gain the benefits of diversifying economic and political risks, you must accept the risk of tracking error.
Most investors never question a divergence in their returns from a benchmark when it’s positive. In fact, I’ve never met an investor who has asked me about that. However, if you have significant positive tracking error, you can also have significant negative tracking error. When tracking error is negative, it can lead investors to question, and even abandon, their investment plans. And that’s the danger.
Investors subject to tracking-error regret make the mistake I call “confusing strategy and outcome.” In an uncertain world, we should not judge a strategy by the outcome without considering what alternatives might have come to pass.
In other words, a strategy must be judged as correct or wrong before we know the results. If you are going to make this mistake, then, in my opinion, you are best served by forgoing the benefits of diversification.
Emerging Markets Have Even Higher Expected Returns
We can also increase expected returns by increasing a portfolio’s allocation to emerging market stocks. The CAPE 10 for emerging market stocks currently is about 12. That, in turn, produces an earnings yield of 8.5%, and an adjusted real return forecast of 9.4%. Thus, a 10% increase in your allocation to emerging market stocks, relative to U.S. stocks, results in an increase in portfolio expected returns of 0.94%.
Given that emerging market stocks make up about one-fourth of the market capitalization of international stocks, a good starting point for allocating to this asset class is 12.5% of the equity allocation (50% x 25%). Relative to the expected return on non-U.S. developed-market stocks, emerging markets have a 2 percentage point higher expected return.
The caveat here is that the higher expected returns to emerging market stocks aren’t a free lunch. It entails taking more risk. But again, emerging market equities provide an additional diversification benefit. Thus, I consider increasing the allocation to that asset class as superior to increasing the overall equity allocation.
Later this week, we’ll discuss some additional steps investors can take to increase their portfolio’s expected returns. We’ll also provide a warning about risk assets, as well as review two ways to use investment factors to your advantage.
This commentary originally appeared December 21 on ETF.com
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